IC-DISC: Reevaluating The Benefits After Tax Reform
Posted May 2019
The interest charge domestic international sales corporation (IC-DISC) is one of the few remaining tax incentives for U.S. exporters. It allows eligible businesses to convert a portion of their export income into lower-taxed dividends and to defer tax on this income until it’s distributed. But while the IC-DISC remains a viable option after the Tax Cuts and Jobs Act of 2017 (TCJA), the act may diminish its benefits. If you have an IC-DISC or are considering one, it’s important to assess whether the potential tax savings justify the cost.
The IC-DISC in a Nutshell
IC-DISCs are subject to many requirements, but in a nutshell they’re tax-exempt “paper” corporations designed to act as sales commission agents for domestic businesses that export U.S.-made products. Although they need to have a bank account, keep separate accounting records, and file tax returns, they need not have an office or employees or perform any services. Typically, IC-DISCs are formed as a subsidiary of an exporter organized as a pass-through entity — such as a partnership, S corporation, or LLC. C corporations can also benefit, but to enjoy the full tax benefits described below, the IC-DISC must be owned directly by the corporation’s individual shareholders rather than as a subsidiary.
An IC-DISC provides two important tax benefits. First, it allows an exporter to take advantage of tax rate arbitrage by converting a portion of its export income, taxed at ordinary income rates, into qualified dividend income taxed at capital gain rates. Here’s how it works: The exporter pays commissions to the IC-DISC, generally up to the greater of:
- 4% of its gross receipts from qualified exports (plus 10% of the IC-DISC’s promotional expenses, if any, attributable to those exports), or
- 50% of its net income from qualified exports (plus 10% of promotional expenses).
Because the commissions are a tax-deductible business expense, they’re excluded from the exporter’s income. And the IC-DISC, as a tax-exempt entity, pays no tax on this income. When the IC-DISC distributes its income — either to its pass-through parent or, in the case of a C corporation, to its individual shareholders — it’s taxed at the qualified dividend rate.
The second benefit of an IC-DISC is the ability of the exporter to defer tax on up to $10 million per year in commissions held by the IC-DISC in exchange for modest interest payments to the IRS.
The TCJA’s Impact
Although some lawmakers wanted to abolish the IC-DISC, it survived the final version of the TCJA. But the act may reduce the benefits of an IC-DISC for some companies. Previously, the top individual income tax rate was 39.6% and the qualified dividend tax rate generally ranged from 15% to 23.8% for higher-income taxpayers (the top federal capital gain rate of 20% plus the 3.8-percent net investment income tax). A pass-through owner in the top tax bracket, for example, would enjoy tax savings equal to 15.8% of commissions run through an IC-DISC (the spread between the 39.6-percent ordinary income rate and the 23.8-percent qualified dividend rate).
The TCJA reduced the top individual rate to 37%. It also established a new “pass-through” deduction, allowing some pass-through owners to deduct up to 20% of their qualified business income (QBI). Under this new regime, a pass-through owner in the highest bracket who qualifies for the deduction with respect to all of his or her income from the company enjoys an effective rate of 29.6%. In other words, the spread between the ordinary income and qualified dividend rates is only 5.8%.
Things are a bit more complicated for exporters organized as C corporations. The TCJA reduced the corporate tax rate from a top rate of 35% to a flat rate of 21%. It also introduced a new Foreign Derived Intangible Income (FDII) deduction, which allows C corporations to deduct 37.5% of qualifying foreign income, including certain income from exported products. At first glance, it would seem that these changes eliminate the benefits of an IC-DISC for many C corporations. But to evaluate the benefits of an IC-DISC, it’s important to consider the impact of double taxation of corporate profits — once at the corporate level and again when it’s distributed to shareholders. Depending on a C corporation’s particular facts and circumstances, an IC-DISC may continue to offer a tax advantage.
Careful Analysis Required
To evaluate the continued viability of an IC-DISC, an exporter should carefully analyze its effective tax rate under the TCJA regime to determine whether an IC-DISC would generate any tax savings. Keep in mind that while the TCJA’s corporate tax changes are permanent, its individual and pass-through changes expire at the end of 2025.